THE WEEKEND AUSTRALIAN, MAY 24-25, 2014 31V1 - AUSE01Z01MA

www.theaustralian.com.au 31 WEALTH

“THE great enemy of the truth is very often not the lie — deliberate, contrived and dishonest — but the myth — persistent, persuasive and unrealistic.”

These words of wisdom from John F. Kennedyapply to many areas of our lives and surely to many aspects of investing.

One myth that seems to continually plague investing frameworks is the efficacy of the price/earnings, or “PE”, ratio in stock valuations. While ubiquitous in the process of many fund managers, it is eerily absent at Montgomery.

Any investor in the stockmarket has surely come across the PE ratio.

It is the ratio of a company’s stock price to itsearnings per share.

It is a sensible first step in trying to provide some meaning to otherwise meaningless parameters in isolation.

Indeed, we estimate as much as 85 per cent ofequity research reports are based on relative multiples and comparisons, so investors can be forgiven for being led down the road of conventional wisdom.

Ask an investor what comes to mind when aPE ratio of, say, six times is offered.

“Cheap” will likely be the first word that comesto mind.

On the other hand, test reactions to a PE ratioof, say, 25 times. “Expensive” will be the response, of course.

If only investing were so easy.Most investors intuitively understand that a

higher PE ratio can be justified if a company’s earnings-per-share is growing more rapidly. After all, if earnings per share are growing at 15 per cent per annum, then in five years, the earnings per share will have doubled.

In a sense, this is like saying the five-year PEratio of the stock is half the level of the current PE ratio. Those who subscribe to such thinking often point to the PE ratio as their tool of choice.

This logic, however, may or may not be valid.To a man with a hammer every problem looks like a nail. The missing ingredient is the investment required to achieve the growth in earnings per share. If earnings per share can grow at 15 per cent per annum without the company having to make any material reinvestments into its business — a rare but highly desirable situation — then a higher PE ratio can absolutely be justified. But what if the company needs to make significant reinvestments into its business, or acquisitions, to achieve such earnings growth? Imagine that, for every incremental dollar of earnings, the company had to spend, say, $20 in capital investments or acquisitions.

Should this company’s earnings per share beworth the same PE multiple as the company described above that does not have to spend anything to achieve its earnings growth? Absolutely not.

Actually, in the latter scenario the more the company invests to grow, the more shareholder value is destroyed and the lower its PE ratio should be. As an aside, the market frequently and perversely gets this back to front, sometimes presenting short selling opportunities.

Another myth associated with the PE ratio isthat it is comparable between the stocks of different companies.

It is certainly more comparable than, say, a company’s stock price — which in isolation is an entirely meaningless number.

But there is a key problem with comparing thePE ratios of different company shares: it implicitly assumes the companies being compared are funded with similar proportions of debt and equity. This is often untrue in practice.

If the revenue line and/or the EBITDA of a company slumps, a shareholder who purchased the company’s shares on a PE ratio of, say, 10, with a large amount of debt, will suffer a much sharper fall in wealth than a shareholder who purchased on the same PE ratio, the shares of a company that had the same earnings but had less debt. Two businesses, identical in every way except for how their assets are funded, will have very different PE multiples, especially if there is a hit to the revenue line.

Investors should proceed with caution whencomparing PE ratios of different companies — particularly when they are in different industries.

The PE ratio can be a helpful first step in providing some meaning to otherwise meaningless isolated parameters.

Yet investors should not be hasty in drawingconclusions from PE ratios without further analysis, particularly with respect to the drivers of earnings growth within the business.

Finally, investors should remember that comparing PE ratios between companies is only valid in particular circumstances.

Roger Montgomery is the founder of Montgomery Investment Management.

Exercise caution when it’s PE time

SMALL-CAP education stockslook set to get a big boost fromthe federal government’s deci-sion to deregulate tertiary edu-cation.

The cut in subsidies to univer-sities and the increasing subsi-dies to private educators willbenefit private providers of after-school education, which provideaccess to diplomas and coursesthat deliver professional qualifi-cations.

Gone is the 25 per cent extrathat students are now charged ifthey wish to get a loan to pay for private tertiary education, en-couraging them to pay upfront,meaning it will cost less toborrow.

Navitas is the bellwether ofthe private education sector,providing step-up courses forstudents who didn’t get themarks to get into university.

Last financial year it achievedjust under $730 million in sales,and made a net profit of $75m.Goldman Sachs was lukewarm,however, in its assessment of the2014 budget’s impact on thecompany whose market cap is$2.8 billion.

This could be because the de-tails of the degree of subsidies toprivate educators aren’t yetknown, but it could also be be-cause Navitas trades on a price-earnings ratio of about 30 times.

The real beneficiaries will bethose private tertiary educationproviders that are much smaller(and newer), namely RedhillEducation (RDH) and Acade-mies Australia (AKG), whichtrade on multiples closer to 10times.

These companies have mar-ket caps of $30m and $60m re-spectively. Both educate

domestic and international stu-dents at all levels, providing En-glish language courses throughto “Master degree courses”, asAcademies Australia’s websiteputs it.

This company’s sales last yearwere $36m, delivering a net prof-it of $3.3m.

One investor across thesmaller end of this sector is MikeTaylor, founder of New Zealand-based fund manager Pie Funds.Not surprisingly, he is in favourof the new education policies.

“Deregulation is positive be-cause (private educators) cannow can compete on a moreeven footing with public univer-sities.

“The fee increases for highereducation because of the fundingcuts mean private operators lookmore attractive.” He says beyondthe budget’s measures, these ed-ucators should deliver profitgrowth because of an increasingflow of students to Australiafrom overseas.

Not all education providersare set to benefit, however.Vocation is a provider of trainingservices such as literacy support,and introductory courses and itlisted on the Australian securi-ties late last year. One of the 10programs the governmentpulled to cut $1bn across fiveyears was the National Work-force Development Fund, whichprovided about 7 per cent of Vo-cation’s revenues, according toone analyst.

Richard Hemming is an independent analyst who edits www.undertheradarreport.com.au. The author does not own shares the stocks mentioned.

Education stocks rise as unis lose their subsidies

RICHARD HEMMING

UNDER THE RADAR

Seven opportunities to consider

SOMETIMES it’s fun just to standback and look across the marketsto determine where the good in-vestment opportunities are at anygiven time. In mid-2014 we’ve gotsome clear basics to work with: re-cord low interest rates, a livelysharemarket and an improvingproperty market. Obviously everyidea here carries conventionalwarnings: shares can be volatile,property is prone to cycles and un-listed trusts are illiquid (not easy tobuy and sell). Separately, some —but not all — of these ideas havebeen recent recommendations atEureka Report. With these key fac-tors in mind, we offer seven inter-esting investment ideas.

Unlisted property trusts: Theyhave a mixed history and they lackthe transparency of listed trustsbut they have been making verygood returns and there are specifictax advantages in this area. Bigplayers in the space would be oper-ators such as Charter Hall andCromwell Group.

Some of the best financial ad-visers have been pointing inves-tors towards unlisted trusts inrecent times because open-endedcontinuous trusts have substantialnon-taxable income due to signifi-cant depreciation deductions —income yields average about 8 percent a year.

An ASX 200 Index fund:Here’s the thing: seven years agothe ASX 200 was at 6800 whiletoday it is at 5480. We have a con-siderable way to go before we getback to where we were in 2007.Keep in mind that the US passedits 2007, pre-global financial crisishigh many months ago. What’smore, the sharemarket — unlikethe residential real estate market— is not expensive on a range ofkey measures. In the absence of in-flation, worldwide equity marketshave an ongoing catalyst fromeasy monetary policy.

There will be shocks along theway but the ASX has returned12 per cent a year in total returnson average for a century and it’s areasonable assumption that it will

manage that number in futureyears. Index funds remove allthinking and worrying from thesharemarket process; you simplybuy the index with all that’s goodand all that’s bad and get an aver-age return, which may suit manypeople these days.

Direct property: It must beBrisbane’s turn. The two larger cit-ies of Sydney and Melbourne havebeen racing ahead for 18 monthswith returns in double figures.

Oddly, Brisbane, though it washit hardest post GFC with theflooding of the Brisbane River, hasfailed to get back on track.

The city’s price growth trailsthe Sydney and Melbourne re-turns for no obvious reason otherthan a ‘‘time lag’’ — propertyyields across the city are as goodand regularly better than the larg-er cities.

Virtually every property ana-lyst says Brisbane is next in the na-tional recovery. And with one infour new properties in Queens-land being purchased by foreignbuyers, according to RP Data,Brisbane is the standout residen-tial opportunity this year.

A takeover target: With theblitz of activity around TreasuryWines, Goodman Fielder andDavid Jones, takeover fever is inthe air. The nature of takeover ac-tivity is something akin to a dom-ino effect — once the first movesare made, everyone must get intothe game.

If you want evidence, recallhow Saputo of Canada’s bid forWarrnambool Cheese and Butterlast year triggered a doubling inthe share price and the arrival of atleast four international food com-panies to the bidding process.

There are dozens of targets tochoose from in the current market:One lesser known candidate is thehealthcare stock Azure, a ‘‘buy’’recommendation at Eureka Re-port. The healthcare group re-cently rejected a takeover attemptfrom an unnamed suitor but thestock price remains firm, a signsurely that this company is capableof making it on its own. That said,sooner or later another predatorcould arrive on the scene.

BHP Billiton: In anyone’s eyesit’s a ‘‘value opportunity’’ thoughpatience may be needed. It’s one ofthe world’s greatest mining com-panies, locally listed and planninga spin-off. Even with $100 a tonneiron ore prices, when you are pro-ducing at $40 a tonne you can onlywin when the smaller miners getcrushed.

Moreover, BHP is being namedas a buy across the world; stock-

broker Cazenove of London andBarrons magazine of New Yorkhave recently added their weightto the recommendation.

For many Australian investorsthe issue is that they already haveBHP in their portfolios and mayhave witnessed the stock soar anddrop through different phases ofthe mining cycle.

For newbies, though, it looks

awfully attractive on a price-earn-ings ratio of 11 times and a dividendyield of 3.47 per cent.

A gold exchange-traded fund:Every diversified portfolio shouldhave gold — and, unlike a lot ofrival asset classes, gold is nowthought to be nearing the end of itsdownward price cycle as it hoversat $US1300 an ounce. It is the greatbulwark against inflation, and in-

evitably — as we are endlessly toldby the best minds in business —global money printing is going tounleash inflation.

For many years the only way tobuy gold was in the form of goldbars. (Obviously gold stocks areanother possibility, but here weare talking about gold the com-modity.)

Traditionally, storage was thekey problem: though gold barslook good they are actually awk-ward to keep and costly to secure.Now ETFs such as that offered bystock code GOLD or the PerthMint’s at stock code PMGOLDcan track the pure gold price, al-lowing retail investors a new wayinto the precious metal.

A hybrid hopeful: If you arelooking for a speculative oppor-tunity in the fixed income marketrather than a conventional in-come return, then the Elders Hy-bird is a clearly very special

security at a very special time.Basically this note (stock codeELDPA) and the company behindit have been doing it very tough for a very long time, but in recentmonths there is at last a sense ofturnaround with new chief execu-tive Mark Allison and a return tooperational profitability. Just nowthere is the possibility this hybridwill improve strongly and it maysoon start paying its ‘‘coupon’’ (orregular income) as well. It is trad-ing at $30.

James Kirby is the managing editor of Eureka Report.

$30Elders Hybridclosed steady

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$36.5¢Azure Healthcare

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From stocks to property to gold, there are many prospects

JAMES KIRBY

THERE’S something innately at-tractive about property. It’s tan-gible, it can be beautiful — forhigh-income earners, the assetclass has a lot going for it. How-ever, direct property investmentmay not always be the best way to

have property exposure in yourportfolio. The fixed income assetclass offers alternatives.

For example, investors can ac-quire a senior bond in Stockland,Mirvac or Lend Lease offering aknown return and a known ma-turity date. There is no guessworkin trying to locate growth hotspots or uncertainty regarding re-turn. Investors are beneficial own-ers of the bonds and can buy andsell at their discretion.

Another way to gain propertyexposure through fixed income isvia residential mortgage-backedsecurities.

According to the ReserveBank, as of December 31 last year,

RMBS on issue totalled $104 bil-lion. For the 12 months to April 15this year, there has been morethan $6bn of new RMBS issued.

Investors in individual residen-tial properties face concentrationrisk, illiquidity (it’s hard to sell 10per cent of the value of a propertyto fund a holiday or family emer-gency) and unknown returnsgiven vacancies, unplanned main-tenance and expenditure, andvariable interest rates.

However, by combining manymortgages into a large and diversi-fied pool via a trust, then breakingthe pool into smaller, marketableclasses, the RMBS becomes at-tractive to investors.

Different classes of RMBSoffer a spectrum of risk althoughthey are typically low-risk due tohigh underwriting standards, con-servative loan-to-value ratios (av-eraging about 70 per cent) and thefact loans retain full recourse tothe borrower if selling the prop-erty can’t recover the borrowedfunds.

RMBS passes through theprincipal repayments from thepool of mortgages, unlike bondsthat pay interest and principal atmaturity, so RMBS terms can bequite short. The concept of break-ing the pool into varying classes ofsecurities allows investors withspecific risk appetites to target the

appropriate class and returns. In this way the classes act like a

normal company capital struc-ture, where investors with the low-est risk appetite target seniorbonds (or in the case of RMBS, thehighest classes) and those with ahigher appetite target lowerranked capital, such as hybrids orshares (or in the case of RMBS, thelowest ranking classes).

The example shown was anRMBS issued by AMP in March,which originally targeted capitalof $500 million, but due to stronginvestor demand was upsized to$1bn. The loans on average havebeen operating for three years. Allthe loans have lenders’ mortgage

insurance, which completely cov-ers any losses. RMBS developeddue to the need of financial insti-tutions to source funding for theirlending activities. Virtually allAustralian Prudential RegulationAuthority regulated lenders useRMBS as a source of funding.

RMBS is a low-risk investmentthat is in high demand and tightlyheld. If you are interested in thesesecurities, contact a bond brokeras they are available only in theover-the-counter market.

Elizabeth Moran is a director of education and research at FIIG Fixed Income Specialists. www.fiig.com.au

RMB securities are an indirect route to property for all levels of risk

ROGER MONTGOMERY

LIZ MORANSMART INCOME

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‘Private operators look more attractive’

MIKE TAYLORPIE FUNDS

Bankers come out swinging over FoFA

THERE were 33 organisationspitching their ideological wareson Thursday in Canberra overpossible changes to the Future ofFinancial Advice legislation, butreally only two opposing factions.

The fault line was exposed yes-terday more clearly than at anypoint in the past when the Austra-lian Bankers Association, a sup-porter of the Coalition’s plannedchanges, came out swinging yes-terday against Industry Superan-nuation Australia, which hatesthem.

They had both presented to theSenate economics committee forand against the Coalition’s plan-ned changes to Labor’s FoFAlegislation, which came into lawon July 1 last year, and ISA subse-quently accused the banks ofwanting to dilute the “best inter-ests’’ duty of advisers to their cli-ents, and wanting to re-allow thepayment of conflicted payments,among other things.

The changes look likely to begenerally adopted and recom-mended in a report from the bi-partisan committee, due to bepublished just before July 1 whenthe Senate sees the arrival of the

unpredictable Palmer UnitedParty.

The most contentious propos-als include taking a “catch-all’’clause out of a seven-clause defi-nition of the “best interest” dutythat binds adviser’s to their clients,and removing the “opt-in” rulesthat forces planners to be effec-tively re-engaged every two years.

Diane Tate, acting chief execu-tive of the Australian Bankers As-sociation, said yesterday her

industry had been misrepres-ented by ISA. “The banking in-dustry strongly supports theoriginal policy intent of the FoFAreforms, including the best inter-ests duty and the ban on conflict-ed payments,’’ she said.

“The ABA is not seekingchanges to enable banks to chargeor reintroduce commissions. TheABA is not seeking changes todilute the best interests duty.’’

She said the banks had beengranted a number of exemptionsin the original FoFA to provideadvice to customers but that theydid not work properly.

“We’re not asking for the exist-ing basic banking exemptions tobe expanded; we simply wantthem to work properly together.’’

The exemptions were grantedfor a year from July 1 last year be-cause the matter had not beenfully resolved, meaning that thefuture after July 1 this year is stilluncertain even though that is the

start date for a new workplaceagreement covering how bankemployees are paid.

They are part of the regula-tions that accompanied the intro-duction of FoFA and, unless theyare changed, after July 1 there is adanger that payments for generaladvice by bank employees may beconsidered to be “conflicted.’’

Ms Tate said that bank staff didnot get paid commissions but re-ceived a salary “and may haveaccess to a performance bonuspaid subject to a balanced score-card’’. She said the banks weremerely seeking “technicalamendments’’ that would stillallow customer protections suchas the ban on convicted paymentsto be maintained.

“General advice is freely avail-able from banks throughbranches and websites,’’ she said.

“You don’t even have to be acustomer to get this advice.

“All we are seeking is to makesure that banks don’t have to putin place new compliance pro-cesses, which make providing thisinformation more difficult.

“FoFA was never intended toinclude bank tellers and bank spe-cialists who provide informationfor customers wanting to open abank account or get advice onother banking products.’’

ANDREW MAINFINANCIAL ADVICE

Although Brisbane’s price growth trails Sydney and Melbourne returns, property yields are regularly better than the larger cities

Diane Tate

‘FoFA was never intended to includebank tellers’

DIANE TATE